There are a number of reasons as to why you would want to take out a loan to finance your business venture. These reasons may include the following:
- Retain total control of the business: In contrast to equity investments, when a business owner applies for a loan to finance their business, they will not be required to give away any stakes in their business in exchange for the loan money. Instead, the business owner will retain their status and thus will be granted the right to make any major decisions about their company themselves.
- Recoup major portion of the profits: Similar to why business owners take out loans from a bank, as opposed to offering shares to equity investors in exchange for money, a loan means not having to give away shares and that the business owner can keep the majority of their profits. The only money that the business owner will need to pay to a lender like a bank are the payments to pay off a business loan and any accrued interest.
- Interests can be written off: As mentioned above, a business owner will need to pay off any loan debt, including the interests accrued on the business loan. However, a business owner will typically be allowed to write off interest payments on a loan as a business expense when it comes time to pay for and file their business tax returns.
- Build a credit history: In general, the better credit history that a person or entity has, the easier it is to apply and obtain a loan from a bank. By taking out a loan and making principal loan payments on time, a business can build their credit history, which can make it easier for the business to ask a bank for bigger loans in the future. Having a loan can also provide a business the opportunity to make network connections and establish a solid business relationship with a specific lender.
- Purchase business equipment: A business owner may consider taking out a loan when they need to purchase equipment in order to get their business up and running. For example, a manufacturing plant may need to buy equipment in order to make its products. Purchasing equipment can be a costly business expense. Thus, obtaining a loan will allow a business owner to start creating their products or services, so that they can begin generating revenue for their business.
- Seize a good business opportunity: In some cases, a business owner may encounter a business opportunity that is either too good to pass on or that they predict will be very profitable. Rather than losing the opportunity to capitalize on the business venture, a business owner may apply for a loan to ensure they can finance it until the business starts making money. It should be noted, however, that this is a risky reason to take out a loan for a business and thus should be used sparingly as justification for a loan.
Why Would I Not Want Take Out a Loan for My Business?
On the other hand, there are plenty of reasons why a business owner would not want to take out a loan for their business. At the very least, a business owner should consider the potential consequences they could face when taking out a business loan. This is especially true in cases where a business is not generating enough profits and/or growing as quickly as a business owner had initially hoped or predicted.
Some examples of reasons why a business owner would not want to take out a loan for their business include:
- Ongoing business expenses: One of the main reasons why a business would want to avoid taking out a loan for their business is the fact that they consistently have to make principal and interest payments on a business loan. This can be a burden on a company that is barely breaking even and will appear as a large monthly expense on accounting reports.
- Lack of funds: Given the fact that the business will need to make ongoing payments on a loan, this could interfere with the business’s capacity to use the money for other purposes like buying equipment, inventory, and various other types of business-related expenses that may arise.
- Loss of assets: When someone takes out a loan, the lender will typically require that the borrower provide some sort of security to back the loan in case the borrower defaults on payments. For example, a bank may ask that a business use its office space (if owned) or equipment and inventory as security for the loan. Thus, if a business is unable to make loan payments because they are not turning a profit, then their company may be seized by the lender in order to pay off their debts.
Why Would I Want to Raise Money for My Business through Equity Investors?
There are some situations in which a business owner may decide that a bank loan is not the right option to fund their business. In these cases, a business owner may choose to raise money by asking others to invest in their business. While this may not be the best method to use in every instance, raising money for a business through equity investors can offer a few important benefits, such as:
- A business owner will not need to make principal or interest payments on the original investment money like they would on a business loan from a lender. Instead, the equity investors will be repaid by being granted a certain percentage of the business (e.g., shares or stocks).
- Equity investors are typically individuals who have strong business acumen. Thus, equity investors can often provide support and offer valid advice about the business. In other words, it is like having a business advisor on staff who has an incentive for the company to do well or else the business will not make any money.
- As mentioned, a business owner will not be obligated to repay an equity investor since the investor is taking a risk with their own money that the business will succeed. Accordingly, if the business fails, the business owner will not be required to pay back the money like they would if the money was given to them as a business loan from a bank.
- One last advantage of raising money through an equity investor is that it will not appear as a monthly business expense as it would with a bank loan. This can free up the business’s expense accounts for other things like purchasing inventory or equipment.
Any Reasons I Would Want to Avoid Using Equity Investors?
On the other hand, there are a couple of reasons as to why a business owner would want to avoid using equity investors to finance their business. These include:
- A business owner will need to give up shares and control over some portion of their company in exchange for receiving money from an equity investor to support their business.
- It can be just as expensive to buy out an equity investor as it is to make principal and interest payments on a business loan. In most instances, buying out an equity investor will usually be more costly than the original contribution that they invested in a business.
- As mentioned, an equity investor will invest in a company in exchange for a portion of the business. Thus, it can be very difficult for a business owner to find an equity investor who is not only willing to invest in their business idea, but is also someone whom they can trust to make good decisions for their company.
- In some instances, it may be challenging to find an equity investor who is willing to invest in a business. As such, a business owner may be forced to give away a greater portion of their company in order to convince equity investors to invest in their business.
- A business owner will also have a fiduciary duty to its equity investors. Therefore, if a business owner fails to operate their business in an ethical, legal, and reasonable manner, then they could potentially be subject to a lawsuit by their equity investors.
Which Way of Financing My Business Would Be Best for Me?
Generally speaking, owners of start-up businesses are typically better off obtaining financing for their business by raising capital through equity investors. Unlike a business loan, a business owner will only need to pay back their equity once the business becomes profitable.
Even after the business becomes profitable, the return money will come in the form of company stock. Thus, if an equity investor retains their shares, the money will not need to be paid out until they sell them.
On the other hand, if your business is already up and running, then a loan may be the better financing option. A loan is best for companies that are already generating revenue. However, it may be in your best interest to obtain expert advice from a local corporate attorney. An experienced business attorney will not only be able to provide valuable advice on this matter, but can also discuss the potential tax implications for either option of financing your business.